Investment thesis

• Extremely attractive risk/reward: opportunity to short a shrinking retailer at 30x+ 2013 EPS
• Weak regional department store in secular decline; 10 year sales CAGR is negative 3.5%
• Problems are structural: increasing competition, bad real estate, decades of underinvestment in stores, SG&A
• Credit income accounts for 1/3 of EBIT and this profit pool at risk since agreement expires in 3 years
• DDS is the weakest competitor of the regional dept store industry, an industry that is in slow decline
• Family ownership and Board composition mean that change is not on the horizon

Historical financials

Attractive risk / reward:

Downside is that DDS can "fix" its gross margins, so assume that DDS somehow gets its gross margins in-line with its

competitors (Macy's, JC Penneys, Kohls, etc.) and achieves a ~40% gross margin. EPS at the current $6B sales base would = $3.00.

Capitalize these peak earnings at a Macy's like P/E of 11x and your downside is $33 or about 7%.

Upside scenario is that DDS sees sales decline in 2011 at 1.8% (which would be about ½ the l-t 10 year CAGR that DDS has witnessed) and

the resultant EPS assuming flat gross margins which is a stretch, DDS would earn $1.72.

DDS is a declining asset - a retailer that year in and year out sees a lower sales base; DDS is trading at a nosebleed 17.9x P/E given this

declining sales characteristic.

DDS is in a long term secular decline:

Sales have compounded negative 3.5% for the last 10 years

DDS problems are structural: bad locations, underinvestment over decades:

DDS's problems are structural: more specifically this is reflected in the fact that DDS suffers from a low sales per square foot problem not from a

margin problem; in fact, DDS margins appear too high as DDS has underinvested in SG&A (primarily labor and advertising)

• DDS has only 1 employee for every 12,000 square feet of selling space while competitors have 1 employee covering every 400-900 square ft
  
  • (see above table)
• DDS has underinvested in advertising as its advertising / sales ratio is significantly lower than the peer set (see above table)
• Therefore, DDS margins are not the issue: in fact, DDS needs more expense investment and margins are unsustainably high

DDS suffers from poor real estate that skews to lower income areas:

• An analysis of DDS's real estate proves out that DDS's locations skew to areas with median HH incomes of $44,000, 
  • approximately 20% lower income than the national median.
• Interestingly, DDS claims to cater to a higher end shopper, the Nordstrom's shopper
• Given that DDS owns 78% of its real estate, the problem is hard to fix

DDS has underinvested in its stores for decades....while competitors spend $3-15 per square foot of selling space, DDS spends only $1

(see above table)

DDS is dependant on credit income from a JV with General Electric Consumer Finance for 40%+ of LTM EBIT

This agreement expires in 3 years, highlighting the risk to DDS EPS

GE is unlikely to renew the agreement under similar terms according to competitors and former employees, potentially forcing DDS to see

credit income decline materially, or even worse to take the credit receivables back on its own balance sheet

DDS is losing share within a declining industry:

Department store industry sales have declined 2.4% over the past decade, and DDS is a share loser within this declining industry

Dillard's family manages DDS, controls the board and 20+ interviews with former Dillard's executives, competitors, etc confirm that change is not on

the horizon

The Bull Case

o   Dillard's has excellent real estate that is not properly valued

Even using an aggressive cap rate for Dillard's generally low quality to mediocre real estate, it is hard to get anywhere close to the current share price;

moreover, real estate experts we have spoken to have noted that Dillard's recent real estate has sold for solidly double digit cap rates (12%+).

Using a more conservative cap rate, say 10% and the entire business is only worth $21.62

o   Bull case #2: DDS will benefit as the US consumer recovers given the operating leverage and the cyclical decline in demand

This is not a cylical issue-DDS lost market share, saw sales, market share and margins decline during the greatest period of growth

for theUS consumer (1999-2006): DDS' comparable store sales are still flat in 2010 even as competitors have returned to positive

and even as DDS is comparing against -7% and -10% comps in 2008 and 2009